Marko Polojärvi

Thought Works

light bulb by Edison

Bitcoin - Societal Evolution Accelerator

Bitcoin has increased its valuation against the American dollar from ~$100 to ~$1100 in 3 months. This is absolutely insane growth. Normally things just simply don't grow that fast in this world. Could it be that we're in the grip of monetary revolution where transfer fees are trivially low, there's no central authority and everybody can use their computer to generate money? That's the pitch anyway.

In this thought work you will find out why your life will be permanently changed by what the invention of Bitcoin signifies.

Community effort revolution

There's a lot of mystery around how Bitcoin works but in practice it's quite simple. In a nutshell Bitcoin is nothing more than a huge append-only chronologically ordered public list of verified transactions shared between everybody running a Bitcoin Wallet application. When you send money from your wallet to Pete's wallet, the transaction is first verified and then cemented on the list. It's all random-looking ids so by looking at transactions alone nobody can identify who owns a specific wallet. Bitcoin senders and receivers read the transaction list directly thus they don't need to communicate with each other.

Some of the users are running bitcoin software in "mining mode". In essence, miners verify other people's transactions in order to prevent the "double spend" problem from happening. Double spending means spending the exact same unit of currency twice. In the physical world you obviously can't use the same euro coin twice without giving it up but in the digital world it's trivial to replicate bits. The most important job miners do is to prevent double usage and if the Bitcoin network is working as designed, Bitcoin's design virtually guarantees there won't be double spending. These same processes also make Bitcoin fraud-proof.

community effortNew bitcoins are created when "the miner gets lucky". I won't go into in-depth details how "the miner gets lucky" because it's a bit out of scope for this essay but essentially the miner's computer tries to solve a hard mathematical problem. If the computer successfully solves the problem, the network rewards him or her by creating a bunch of brand new bitcoins and sending them to the miner's wallet. The mining process was designed so that it is computationally demanding but still so predictable that it can be set prehand how often and how many new bitcoins are created. The chances of solving the mathematical problem gets smaller and smaller as time passes. Currently 25 bitcoins are created approximately every 10 minutes. The number of bitcoins created halves every 4 years. The production will continue until all of the 21 million possible bitcoins have been mined. Contrary to traditional currency, with Bitcoin nobody can simply turn on the printer when they run out of money. At maximum there will be 21 million bitcoins and that's it. If you're interested in the technical details of mining, dig deep into Bitcoin's wiki. But for our purposes you now know everything you need to know.

Mitigating the double spend problem in a completely decentralized manner makes Bitcoin the first truly viable online currency without any single point of failure. The power of Bitcoin lies in the fact that no one entity can control the supply, distribution or transactions of bitcoins. This means that it can't be controlled by governments or other entities that have traditionally used money as a tool of leverage over their citizens.

So all in all Bitcoin is a community effort that works as a currency only if there are enough miners making sure that it's trustworthy.

The value of ones and zeros

Alexander's coinWhen you explain Bitcoin to a person who has never heard of it the first question usually is how can it be valuable because it's just ones and zeros? In reality almost all currencies nowadays are just bits. For example the dollar's link to the gold standard was severed in the 1930s after The Great Depression. Another misconception is that for every dollar in circulation there needs to be a paper bill in some vault somewhere. In reality only a small fraction of money in circulation exists in the physical world. It's all just ones and zeroes with mutually agreed value. I know from personal experience, and from talking with others, that the previous sentence is quick and easy to read and agree on, but it's hard to grasp mentally what it actually means in terms of how our society is built. Once you do understand it at a deeper level, you'll be a much freer human being when it comes to the pressures of "succeeding" in today's world.

To give you some context about in what kind of market Bitcoin is trying to disrupt, the world's largest financial service companies annual sales are over over 5000 billion/5 trillion (5000000000000) dollars. Banking alone is 2.6 trillion dollars. For comparison the whole entertainment industry is ~400 billion/0.4 trillion, roughly the same as the technology industry. Energy and pharmaceutical industries are around 1.2 trillion dollars. So nothing comes even close to the financial sector.

Bitcoin has had a huge few months. I'm writing this in December 2013 and after a few turbulent weeks people seem to value 1 bitcoin as highly as ~$850. It passed the value of gold (~$1200) at one point. A few months back 1 bitcoin was worth ~$100. That is amazing when you consider that a bitcoin is just something that a network of computers solving mathematical problems created. Right now Bitcoin's market capitalization is roughly 11 billion. If the annual sales of banking is 2600 billion, Bitcoin has reached 0.4% of that. It's unrealistic to expect Bitcoin to take over the whole banking industry but no matter how you look at it, the potential sure looks big.

Fool.com even dared to ask if 1 bitcoin could even be worth of 1 million dollars if "big money" gets involved. Investment firm Wedbush Securities was a bit more cautious when they suggested the value might reach $98500.

What makes the situation interesting is that here in Finland you can't actually buy anything with bitcoin, or at least I haven't seen anything (please let me know if you have). So why on earth would I give up 600€ to get 1 bitcoin? For many people living in major Finnish cities in an average 50m2 flat, that's roughly a month's rent. Am I suppose to just take all these claims for the future at face value and jump in?

Dis/illusion of Bitcoin's value

Everything has a value and the value is in the eye of the beholder. In the online currency markets people are buying and selling cryptocurrencies like Bitcoin with surprisingly big volumes every hour of the day. This is supply and demand in progress, right? Actually no. Or at least not the way people think.

InvestorsPeople are currently investing in Bitcoin. They are trying to buy low so they can profit later on by selling high - normal procedure in all investing. Here lies the problem. Bitcoin wasn't intended to be an investment instrument - it was meant to be a container of value, in other words, a unit of currency.

Buying and selling currencies has been around for a long time but with Bitcoin it's a bit different. Traditional currencies like the euro are in everyday use and the value is based on real-life nation-wide economies. This means the fluctuations are small unless there's some nation-shattering event. Bitcoin hasn't reached this stage yet. You can't buy eggs from the grocery store with bitcoins. The main value driver in Bitcoin are the dreams of tomorrow's value expectations, and the expectations range from huge to unrealistically insane.

When the media starts losing interest in the bitcoin phenomenon, its market growth will slow down and the market will start to adjust to the fact that demand is slowing down. What happens when people who have invested in Bitcoin notice that growth has stopped? They sell and they sell fast. Many will invest in alternative cryptocurrencies and then try to hype it in the hopes of repeating Bitcoin's growth pattern.

In early December 2013 China announced that they had banned banks from trading in bitcoin. As a result Baidu (China's Google) stopped accepting bitcoins. This news was enough to send cryptocurrency exchanges in a huge downward spiral and BTC/USD went from $1200 to $700 in a few short days. This was one single piece of news from one day but still caused huge ups and downs because everybody is watching the news finger on a trigger to sell or buy. The market is far from stabilizing.

Interestingly there is another financial instrument that behaves in a similar way - speculative penny stocks. The difference is that speculative penny stocks are valued under $5, Bitcoin is $1000 and penny stocks are "regulated".

The only concrete value Bitcoin has at the moment is the network. The network has gathered immense power to verify transactions and to provide a secure value exchange. Everything else around Bitcoin at the moment is just dreams and hopes for the future. The question is if Bitcoin fails as a currency for the everyman, how much is that network worth? The secret of Bitcoin's revolutionary nature lies in its network. However most people are investing in Bitcoin with hopes that it will be adopted as a currency used every day.

Interestingly many people don't have a clue that the Bitcoin protocol has multiple models for transactions between users. It's not only Alice sending money to Bob. There is also a model called m-of-n transaction which allows Alice to send bitcoins to Bob but Bob will only get them if Carl agrees. In the middle of a m-of-n transaction Carl doesn't hold the coins and Alice can't reuse them but it depends on Carl's decision if the transaction is accepted or declined. This means you can have an independent third party that resolves conflicts between sender and receiver. This is useful if for example you sell something highly expensive via the postal service and your buyer then claims he never got the package. Now it's the third party's job to investigate and either complete or cancel the transaction. This model alone creates an interesting scenarios for private courts.

The life of a Bitcoin adopter

The chicken and egg analogy comes up a lot when the topic is Bitcoin adoption. If merchants don't accept Bitcoin, customers won't have any need to own any Bitcoins. But the issue is a bit broader than that. Before there can be an egg or a chicken there needs to be a viable environment for them to live in. Currently Bitcoin is so volatile that nobody with something to lose would base their life on Bitcoin.

Imagine if your employer asked you if he could pay your salary in bitcoins. Would you take it?

Early adoptersLet's imagine a small scenario from the life of an early adopter who has chosen his salary to be paid in bitcoins. On 15th January the early adopter receives 4 bitcoins as a salary. One bitcoin is worth 1000€ when he receives his bitcoins so the value of his salary is 4000€. His rent is 1000€ and the landlord is so nice that he accepts bitcoins. The day before the rent is due BTC/EUR drops to 900€. I can guarantee that the landlord will still ask the early adopter to pay 1000€ even if the value of his 4 BTC salary has just been reduced to 3600€. Of course the early adopter might also get lucky and his salary's value increases. Great news for the early adopter, but not for his employer. I can pretty much guarantee that very, very few companies will operate purely in bitcoins in the near future if everybody from the company's customers to suppliers operates in currencies like EUR or USD. This means that unless the work contract say that the salary is X amount of BTC, it's more than probable that the early adopter's salary will be based on the primary currency, and when the salary is paid, exchanged to bitcoins will be based on the day's exchange rate. So in the end the early adopter gains very little benefit from accepting his salary in bitcoins instead of a primary currency.

Both the merchant and the customer must work primarily with bitcoins, and more importantly value everything only in bitcoins to make it work. The unfair readjustment scenario above will always play out unless Bitcoin somehow stabilizes, or Bitcoin somehow turns into a primary currency. The whole production chain must switch to Bitcoin for full adoption.

One benefit for merchants worth mentioning is the very low transfer fees. This is a huge benefit because it has been estimated that smaller shops pay roughly half of their profits in credit card fees. Bitcoin reduces this to a trivial level and it's paid by the person making the transaction (customer) so merchants get to enjoy free transactions and hopefully pass on the savings to the customers. My business experience is purely from online so I don't know how much those card readers and associated fees are, but in the online world for example PayPal charges 2.9% + $0.30 domestically and 3.4-3.9% internationally per credit card transaction. In the digital realm profit margins are usually much higher so it's not hard to imagine how much merchants are squeezed by payment processing fees. Technically there is no requirement for processing fees in Bitcoin but today they are used to incentivize miners to process transactions faster.

Unfortunately I have my doubts about bitcoin stabilizing as long as it's treated as an investment instrument. Stability is not an investor's friend. What investors want is volatility and market events to capitalize on.

So the same forces that are now thought of as being helpful are actually causing harm in the long run.

Another angle to consider is that you'll have a hard time finding these early adopters because nobody really cares about the market value of their currency. It's all about what it can buy and I need to be able to trust that roughly the same amount of euros has the same buying power tomorrow. So if Bitcoin ever makes it as a “real currency", people won't care about its valuation. They just want to buy some food and pay their rent.

All in all, Bitcoin's greatest obstacle is to establish itself as a base of value. As long as value is measured in USD or EUR it won't succeed as today's investors dream.

Unleashing and understanding the revolution

Because Bitcoin's codebase is open-source there's as many "alternative coins". Most of them are trying to differentiate with alternative mining algorithms or a bit different properties, like for example how many total coins can be created. These affect the economy around the coin but in many cases the only goal for coin creators is try and get rich quick. Daniel Menger wrote a great article some time ago about how alternative coins will not do any good unless they really bring something new to the table - which they haven't so far.

However there is one alternative coin that goes beyond Bitcoin: Namecoin.

Namecoin takes Bitcoin's idea of trustworthy append-only transactions list and extends Bitcoin's functionality by giving it the ability to store data under user-defined keys. This means that anybody can store data in the list with easy-to-remember keys and miners will make sure that, once confirmed, nobody can modify it. In many ways Namecoin is exactly like Bitcoin but it has a much broader purpose.

The most important thing to understand about Namecoin is that it doesn't aim to be an alternative currency like all the other "alternative coins". Because it has the ability to act as a database, it has the potential to disrupt all industries relying on verifiable transaction ledgers. Especially since the Snowden revelations there's been constant questioning about whether our Internet's current centralized system for website authentication certifications (SSL, the thing that keeps your connection safe), dominated by US-based companies, is a secure enough system. Just as an appetizer, Namecoin not only solves this easily but makes it much better for the user because of the transparency aspect of the Bitcoin/Namecoin public transaction ledger.

This has enormous implications throughout the world: it removes the human labor needed to provide verifiable transaction services for any data. The impact of this can't really be overstated.

TypistThe workforce needed to provide verifiable transaction services in various industries is humongous. A transaction in this context means anything that needs to be written down in a tamper-proof manner which must be verifiable later on. Imagine the impact for our societies if we could free all that human capital from doing transactional work and have people doing work that leverages the unique capabilities of human beings like creativity and problem solving.

For example we could finally have verifiable, tamper-proof electronic voting making democratic societies more transparent.

If you are a creator, you can claim ownership of your work by storing it in the Namecoin's ledger. This works because the time of the transaction is preserved for eternity.

Even if the ledger itself is public and distributed to everybody, you don't have to put your data in as is. You can either encrypt it with your own key or you can create something called a hash out of the original data and store the hash in Namecoin. The hash will act as proof that you had a certain piece of data when you made the transaction.

I hope you still remember that Bitcoin supports multiple transaction models. The m-of-n model combined with Namecoin is something that blows my mind. Imagine storing important contracts (encrypted of course) in Namecoin and using a mutually agreed dispute resolution organization to verify the outcome is as agreed upon. Because private courts are paid by whoever uses them, they can be used for all sorts of different tasks that need an independent party to verify the outcome. Dispute resolution organizations live or die based on their reputation so I would imagine that supply/demand would give us fair and well-adjusted conflict resolution for all our needs.

The resolution of m-of-n transactions can also be automated. You can set up an automated transaction that will happen only if condition X happens. An automated process monitors changes in a condition and acts accordingly. You could sign ownership transfer documents for your assets, encrypt/hash them and store them in Namecoin with a rule that they will be transferred to your wife in case you die. An automated process monitors your nation's online obituaries and tries to find a match. Hopefully your wife has a similar rule set. Because we can now automate these sort of basic transactional legal services, the demand for legal transaction processors, also known as lawyers, will decrease to the point where lawyers are only needed for interpreting the law and representing customers in the court of law.

Namecoin will kickstart the next revolution in the job market. The last revolution happened when robots replaced humans in the factories. In this revolution we will replace transactional jobs in the office. Many people will not be happy about this, just like when robots started "taking people's jobs".

The crucial point I want you to understand is that Namecoin is already ready in many important aspects. The "official" Namecoin application (.bit domain) has been operational for years and there's many smaller projects running on Namecoin. For bigger projects adoption issues are trivial compared with what needs to happen for Bitcoin to become a viable everyday currency. Where Bitcoin relies on the whole value chain accepting it as its basis of value - Namecoin circumvents this problem by enabling itself to be used as a basis for services, fully usable from day one.

Investing in cryptocurrencies

Here's my disclaimer: As soon as I fully wrapped my head around the potential of Namecoin, I traded most of my bitcoins for namecoins at BTC-e. This is not because I don't believe in Bitcoin, or think that Namecoin is superior to Bitcoin. I believe in Bitcoin as a currency, not as an investment. If Bitcoin survives long enough to become a viable currency I won't care what the euro or American dollar value is. Just like I don't care what the euro's value is against the dollar. All I care about is that the same thing costs pretty much the same amount tomorrow as it costs today. If Bitcoin rises to anywhere near that 1 million dollar valuation, or even that $98000, I won't be crying over the lost millions because what matters for me is that cryptocurrencies succeed. The changes cryptocurrencies like Bitcoin and Namecoin will bring to the world, and especially to poor, oppressed countries, are more valuable to me than any monetary amount. Money is nice but I enjoy the betterment of human condition more.

Namecoin is something I believe is truly worth supporting, and I believe it will reward early supporters handsomely on so many different levels. As the world drags itself into the digital age companies and individuals will be looking for a trustworthy and transparent database to store important information. I also expect that at some point the value of Namecoin might be even more than Bitcoin's because while Bitcoin is a carrier of value to be used as a tool for exchange, Namecoin is the carrier of data so important it has the power of changing people's lives.

ChartsSadly as you look at the charts from early December 2013 it's painfully obvious that the Namecoin chart is following Bitcoin's patterns. That's quite clear proof that investors think Namecoin is just another alternative coin instead of something deserving its own valuation. I hope the Bitcoin community will do themselves a favour and start marketing Namecoin also. It would help raise Bitcoin's valuation higher if the common folk knew that the technology of Bitcoin also enables what Namecoin can do. Increasing trust in the Bitcoin technology floats both boats.

One thing you can bet on is that the Bitcoin community will keep the currency alive. If you're not familiar with bitcointalk.org forum I highly recommend checking them out. There's quite a few smart people participating who keep surprising me with their unique insights on the future of currency.

Whether you invest in cryptocurrencies or not, there's one thing I can promise and that's cryptocurrencies are here to stay.

P.S. If you feel like somebody else might benefit from knowing all this about cryptocurrencies, don't hesitate to share the link - thanks!